THOUGHTS FROM MACAU

After one day of meetings, it’s pretty clear that business in Macau remains strong. Storytelling, mostly in the investment community, has emerged to justify the stock collapses, after the fact. New visa restrictions, junket credit problems in some of the outlying China provinces, a forthcoming VIP decline, and other fears/rumors continue to surface. However, we see no evidence to substantiate any of these concerns. We understand that the stock market is a discounting mechanism and macroeconomic concerns are legitimate. But as of right now, there seems to be little to be worried about in Macau other than the macro. In other words, it’s macro time.

Even the table cap issue looks like a non-event. Aside from the fact it is only a policy statement and not a change in law, concessionaires expect the cap to be quite flexible in terms of new properties.

We’ve got more meetings on Thursday, but the interesting takeaway so far may be the near term prospects for SJM, the stock. In addition to strong market numbers for September and the coming Golden Week blowout, there appears to be a few company specific catalysts. SJM management will be at G2E next week and will follow that up with a non-deal road show to New York, Boston, and London. The meetings should alleviate investor concerns about near term trends. More important, SJM is quite the free cash flow story. We expect management will talk up the potential and probability for the company to significantly increase its dividend. SJM can do this while still maintaining same store growth and unit growth with its project in Cotai. In fact, given the free cash flow profile, SJM can finance a higher dividend and construction costs internally. They have HK$14 billion in cash which will likely grow to HK$18 billion by the end of the year.

SJM looks timely and upside potentially huge given the precipitous fall in the stock.

Could be a precursor to the USA earnings season? - Yesterday, Domino’s Pizza U.K. & Ireland Plc, declined the most in six weeks in London after reporting 3Q11 SSS that were slightly disappointing.

A NPD survey is very alarming for restaurant visits. The number of annual restaurant visits by a typical Millennial has plummeted from 245 visits five years ago to 192 this year; that's one less visit every week.

In July, restaurant performance slipped to its lowest level in nearly a year as owners — seeing softening sales — downgraded plans for capital spending and offered up their worst overall performance expectations in 20 months.

WEN has settled a lawsuit filed this summer against its largest franchise group (WendPartners). As part of the agreement, WendPartners franchisees will add bun toasters to its stores.

MCD is now offering a breakfast hot dog and coffee for 10RMB in Shanghai, Beijing, Shenzhen and Guangzhou.

CMG is suffering from rising food costs, according to an article on Forbes.com. The author states that traffic may suffer as the company is forced to take price. The author’s target for the stock is $276.

COSI outperformed yesterday on accelerating volume.

PNRA and DPZ underperformed on strong volume studies.

FULL SERVICE

The casual dining sector was hammered yesterday on the back of Darden’s earnings. Prices were down and volume was higher versus the thirty-day average.

BWLD was the outlier, trading flat on strong volume. Our weekly commodity monitor discusses the positive trend in chicken wing prices which is bearish for BWLD.

RT and DIN were the two stocks that did not see accelerating volume on the downside

Howard Penney

Managing Director

Rory Green

Analyst

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09/29/11 08:53 AM EDT

INITIAL JOBLESS CLAIMS: TECHNICAL ISSUES

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Initial Claims

Initial Claims dropped a spectacular 32k WoW (37k after the revision to the prior week) but this improvement is too good to be true. The Department of Labor reported that an unusual calendar caused the seasonal adjustment to break down. If you look at the NSA chart below, you can see that there's no unusual volatility in this series. There are always big swings in the NSA series around quarter-end, and it appears that the seasonal correction generated a misleading number today.

Unfortunately, it's not time to get excited yet.

2-10 Spread Remains Under Pressure

The current rate environment remains very difficult for bank margins. The 2-10 spread widened 7 bps in the last week to 174 bps.

Mortgage Purchase Applications Continue to Bounce Along the Bottom

Mortgage purchase applications rose 2.6% last week, a small gain off of a low level. For the YTD, purchase apps are running 8.6% lower than the prior year. This is not an encouraging sign for homebuyer demand. Refinance applications rose as mortgage rates fell, gaining 11.2% vs the prior week.

Subsector Performance

The table below shows the performance of financial subsectors over various durations.

Joshua Steiner, CFA

Allison Kaptur

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DRI - A STRONG COMPANY SERVING FATIGUED CONSUMERS

Given that Darden preannounced its fiscal first quarter earnings earlier in the month, there were few surprises in yesterday's EPS release and nothing new to get me really excited to be long the stock. There are, however, a lot of things to think about, not only as it relates to DRI but also the consumer environment in general.

To me, DRI is the epitome of what is wrong with having exposure “Middle America” and the average consumer. In the current environment, in the restaurant space, if a company/concept in not “on trend” with a unique customer appeal there is going to be traffic and spending related issues. The easiest path to attracting more consumers for casual dining companies is through ever-better value offerings. The Olive Garden is set to begin advertising a half Panini sandwich, unlimited soup and/or salad for $6.95 in what is clearly a move to take some traffic from Chili’s.

The Olive Garden is the poster child for some of these issues. The concept is generally very healthy, with very strong average unit volumes, but they are struggling to generate incremental traffic. There are some Olive Garden-specific issues. For instance, their asset base is weak with half of the units needing a major remodel; the fix is 6-12 months away and the advertising is somewhat stale and not driving new consumers to the concept.

Naturally, the company’s first response to immediately prop up sales is to offer lower prices to increase the value perception of the brand. To me that is a reaction or a defensive move not a proactive step in trying to bring in new or lapsed users.

What I worry about most with DRI is the company resorting to too much discounting, as they have done in the past. I know it’s a different management team and Clarence Otis is Joe Lee’s apprentice but I think the $15 price point offer from Red Lobster this past quarter was disconcerting. I know management put their best foot forward with an acceptable rational for the promotion, but the memories of past Red Lobster discounting efforts are still fresh.

For 1Q12, sluggish same-store sales trends at the Olive Garden (reported -2.9%, with traffic down -2.2%), combined with higher commodity costs, resulted in lower year-over-year operating margins and earnings during the first quarter.

Higher than anticipated “check management” during the quarter (consumers, fatigued from macro pressures are purchasing fewer appetizers, drinks and desserts) put increased pressure on margins. Management attributed about one-third of the higher year-over-year food and beverage costs as percentage of sales to this increased “check management.”

DIFFCULT TO SWALLOW GUIDANCE

Darden maintained the fiscal FY12 guidance that it provided when the company preannounced first quarter earnings, including blended same-store sales growth of about 3% at Olive Garden, Red Lobster and LongHorn, operating margin growth and 12-15% earnings growth with “higher confidence at this point in the year in the low end of the range.”

Although these expectations are not out of reach, they rely on the fatigued consumer not being so fatigued. Most notably the company needs to see improved trends at Olive Garden, a moderating level of check management and more favorable commodity costs in the back half of the year. Not to mention the overall environment which relies on an economic recovery that Darden CEO Clarence Otis called “uneven and relatively anemic”.

Management would not provide any details about trends in September, outside of saying that they had “reason to be encouraged.” This was not enough to outweigh investors’ concerns, as evidenced by the stock’s performance yesterday.

If consumers are focused on affordability right now as management stated on its earnings call, and we continue to see a deceleration in overall consumer spending trends, I am not as confident as management that the current level of check management will moderate. As we have seen in the past, impacting many full-service concepts, customers tend to manage their checks lower in order to still dine out during tough economic times. This will likely continue to be a factor until we see steady improvement in the economy. Time will tell. As I wrote earlier, half of The Olive Garden’s store-base needs to be remodeled and that is not going to happen in 2012.

Another financial uncertainty for Darden stems from the company’s expectation for more neutral commodity costs during the second half of the year. Although trends will likely improve year-over-year as a result of easier comparisons, Darden’s guidance relies somewhat on declining costs from current levels. The company has contracted 80% of its commodity costs through the end of the calendar year but only 25% of its costs through the end of its fiscal year, which leaves the company’s income statement fairly exposed during the second half of the fiscal year.

Senior management made a bet that commodity prices will decline and it looks to be a smart move given the current trends.

CAN MANAGEMENT HIT THE 3% SSS TARGET IN 2012?

Turning the Olive Garden around is not going to be an easy and will take time. Management is focused on doing the right things such as improving the core menu and its advertising strategy and refreshing and remodeling its store base, but these steps all take time and trends could get worse before they get better.

The only immediate strategy to increase traffic is to offer lower priced menu options, or what management called “addressing affordability” in an effort to appeal to its customer base that includes a lot of people making less than $60K/year. Although lower prices could drive increased traffic, it will have a negative impact on margins and could permanently push Olive Garden’s average check lower. Given Olive Garden’s aging store base and cash-strapped customer base, I am not convinced the company will see any real improvement in same-store sales trends this year.

Relative to Darden’s full-year same-store sales guidance, if the company maintains the two-year average same-store sales growth trends at Red Lobster, Olive Garden and LongHorn that it achieved during the first quarter for the remainder of the year, it would imply same-store sales growth of about 2.7%, just shy of its 3% target.

So reaching this 3% guidance goal assumes an improvement at Olive Garden, as stated by management, but it also assumes continued momentum at Red Lobster and LongHorn. Given LongHorn’s consistently strong trends in the recent past, I would not be surprised to see the concept’s momentum continue at current levels.

Same-store sales trends at Red Lobster, however, improved nearly 500 bps on a two-year average basis during the quarter and I do not think this level of improvement is necessarily sustainable for the rest of the year. And, if Red Lobster cannot maintain +4.5% two-year average trends, Olive Garden’s performance will have to improve rather significantly on a two-year average basis to achieve 3% same-store sales growth.

Howard Penney

Managing Director

Rory Green

Analyst

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09/29/11 08:00 AM EDT

Reformation Time

This note was originally published
at 8am on September 26, 2011.
INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK
(published by 8am every trading day)
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“There is an embarrassing lack of talent and imagination in the last generation of the technocrats.”

-Victor Davis Hanson

On August 9th, 2011, Hanson published a thought provoking article in the National Review titled “A Tottering Technocracy” that I highly recommend. If you want to stop the losing in this country, first you need to get the ball out of the losers’ hands. Winners win.

“An education-age Reformation is brewing every bit as earth-shattering as its 16th century religious counterpart… So the elites furor grows at those who seek and obtain power, exposure, and influence without the proper background, credentials, or attitude.”

-Victor Davis Hanson (National Review, August 2011)

Losers don’t want to hear this today, tomorrow, or the next day. Especially from me. But, for them, I guess that’s too bad isn’t it? I’m the one hiring and we’re going to do everything we can to be the change we all want to see in this country. We can do this.

Back to the Global Macro Grind…

With global markets hanging on every whisper coming out of Eurocrats from Greece to Germany this morning, our economic freedoms remain in the balance.

What the Europeans ultimately decide to do when they pull out their multi-trillion Euro-TARP bazooka is out of our hands at this point. That said, we can make sure that the likes of Tim Geithner and his compromised and conflicted cronies don’t’ fool us the 2ndtime.

Remember, whatever bazooka took the US Financials up for the short-term remains a national banking embarrassment in this country for the long-term. Letting losers lose is an important principle of “free” markets because, in the end, they’ll lose anyway.

I can’t imagine anyone likes playing the game this way, but we have to play the game that’s in front of us. Here’s your Global Macro calendar of critical catalysts for this week:

Tuesday, Greece’s PM meets with Angela Merkel in Germany

Tuesday, US Federal Reserve President Fisher discusses why he disagreed with Bernanke on implementing the Twist

Wednesday, Bernanke gives a speech on “Emerging Markets” and how his policy to inflate had nothing to do with nothing

Thursday, US GDP for Q211 is released (still subject to 32-81% downside revisions)

Thursday, Germany’s Bundestag votes on the Euro-TARP bazooka

Friday, Congress votes on another Keynesian Spending Bill (and could shut down again if they don’t pass it)

Friday, is month and quarter end for all of the asset managers in our business (watch out for the customary markups)

Why my Macro calendar of catalysts isn’t more data and fundamentally driven is a failure of our financial system’s current architecture in and of itself. If I’ve said this 1000x in the last 3 years, I have said it 10,000x - Big Government Intervention in our markets will continue to have 2 general outputs:

A) Shortened Economic Cycles

B) Amplified Market Volatility

And… so the “furor grows” for calling policy people out on this… the truth hurts.

The truth also reveals new horizons of opportunity. The best news we had last week was that a Strong Dollar can re-build a Strong America. The US Dollar Index was up another +2.5% week-over-week, taking its cumulative appreciation to +7.5% since the end of April.

Strong Dollar Deflates The Inflation. Period.

Week-over-week, here’s how that looked in the Commodity prices:

CRB Commodities Index down -8.5%

Oil down -9.2%

Copper down -16.5%

Yes, the price of Gold and US Equities were down -9.6% and -6.6% respectively. But, that’s good for all of the astute buyers out there who knew Growth Slowing was going to be their 2011 investment theme. The winners are in cash and there’s nothing more a proactively prepared American likes than buying things on sale.

The only people who don’t want a Strong Dollar are the people who don’t get paid by a strong dollar. Follow the money and you’ll usually figure these types of things out. You’ll probably pick up some transparent and accountable friends along the way too.

To one of Washington/Wall Street’s finest central planners, it may sound upside down for me to say that seeing energy stocks and prices at the pump decline in unison is good for America. But that’s exactly what I want them to hear.

They can’t buy my vote of confidence anymore with their fleeting schemes to inflate. It’s Reformation Time in America, indeed.

My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1630-1782, $79.19-85.91, and 1121-1144, respectively.

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